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Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives. 1999 Casualty Loss Reserve Seminar. Scottsdale, Arizona. Presenters. Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service Jay Votta - Principal, Deloitte & Touche LLP

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industry reserve adequacy and other hot topics financial analyst s perspectives

Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives

1999 Casualty Loss Reserve Seminar

Scottsdale, Arizona

presenters
Presenters
  • Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service
  • Jay Votta - Principal, Deloitte & Touche LLP
  • Bill Wilt - Vice President & Senior Analyst, Moody’s Investors Service

Industry Reserve Adequacy - Financial Analyst's Perspectives

discussion topics
Discussion Topics
  • Overview of Reserve Adequacy
    • Results of Moody’s Top 50 Analysis
  • Use of Reserves in Credit and Equity Analysis
    • Reserves play critical role in gauging financial health
  • Reserving Issues in Mergers & Acquisitions
    • Reserves key consideration in structuring deals

Industry Reserve Adequacy - Financial Analyst's Perspectives

goals of session
Goals of Session
  • Discuss macro-level trends in loss reserves
  • Provide insight into how ‘outsiders’ analyze loss reserves
  • Demonstrate importance of reserves in different contexts:
    • Credit Analysis
    • Equity Analysis
    • M&A Activity

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis
Top 50 Analysis
  • Moody’s Analyzed Top 50 P/C Groups
    • Approx. 2/3 industry reserves and surplus
  • Used annual statement data and internal reserve model
    • Excluded A&E, reinsurance, miscellaneous lines
  • Tested results against independent analyses where available
    • Despite limitations, A/S data can provide credible starting point

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis6
Top 50 Analysis

Benefits of Analysis

  • Critical component of capital adequacy and credit analysis
  • Provides greater insight in discussions with companies
  • Independent verification of results
  • Insight into developing trends: quality of earnings, current rate adequacy
  • Separate supportable facts from unsubstantiated rumors in market

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis7
Top 50 Analysis

Conclusions

  • Industrywide $12.6 B redundancy at 12/98
    • Represents abut 4% of Reserves and 4.5% of Surplus
      • PPA, WC provide redundancies; CMP, OL show deficiencies
  • Trends in Reserve Margins are Major Story
    • Margins thinning quickly
  • Differences Between Personal and Commercial Insurers
    • Whoever heard of a negative loss trend?

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis personal lines writer s current position
Top 50 Analysis - Personal Lines Writer’s Current Position

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis retrospective view of ppa
Top 50 Analysis - Retrospective View of PPA

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis10
Top 50 Analysis
  • Findings - Personal Insurers
    • All showed reserve redundancies
    • The story then?
      • Favorable loss trends early-to-mid 1990s
      • Actuaries/management slow to recognize in rates
    • The story now?
      • Most carriers reducing rates, dividends
      • Loss cost trends ticking upward again

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis commercial writer s current position
Top 50 Analysis - Commercial Writer’s Current Position

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis retrospective view of reviewed commercial lines
Top 50 Analysis - Retrospective View of Reviewed Commercial Lines

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis13
Top 50 Analysis
  • Findings - Commercial Insurers
    • More even mix of deficiencies and redundancies
      • WC similarities to PPA
      • legislation and rate reform benefits coupled with loss trends
      • Competition intensifying, loss ratio climbing steadily
    • Significant rate pressures all other commercial lines
      • Most commercial lines show uniformly increasing loss ratio
  • Diversified Insurers
    • Redundancies outweigh deficiencies
      • Favorable PPA and WC experience outweighs other lines

Industry Reserve Adequacy - Financial Analyst's Perspectives

top 50 analysis14
Top 50 Analysis

Conclusions

    • Industry adequately reserved -- for now
    • How actuaries can help:
      • Expand statement of opinion
      • Include detailed footnotes in Schedule P
      • Expand content of actuarial reports and distribution of reports
  • Reserves Used in Variety of Ways by Many Constituencies…Think Beyond Statement of Opinion

Industry Reserve Adequacy - Financial Analyst's Perspectives

industry reserve adequacy beyond the statement of opinion
Industry Reserve Adequacy -- Beyond the Statement of Opinion
  • Moody’s Approach to Insurance Analysis
  • Credit vs. Equity Analysis

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis
Moody’s Approach to Insurance Analysis

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis17
Moody’s Approach to Insurance Analysis

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis analytical approach benchmark
Moody’s Approach to Insurance Analysis Analytical Approach - Benchmark
  • The lowest “Secure” rating has the annual default probability of a “500 Year” event

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis19
Moody’s Approach to Insurance Analysis
  • Traditional Financial Indicators
    • Financial Leverage (Debt/Total Capital)
    • Double Leverage (Inv in Subs+Goodwill)/Equity
    • Fixed Charge Coverage and Cash Flow Coverage
  • In Context of Underlying Business Volatility
  • In Context of Business Cycle
  • Does Legal/Regulatory Structure Inhibit Cash/Capital Flows Across the Group?

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis a practical reserve example
Moody’s Approach to Insurance AnalysisA Practical Reserve Example
  • Your typical property/casualty insurer

Industry Reserve Adequacy - Financial Analyst's Perspectives

moody s approach to insurance analysis a practical reserve example21
Moody’s Approach to Insurance AnalysisA Practical Reserve Example

Industry Reserve Adequacy - Financial Analyst's Perspectives

credit vs equity analysis what creditors policyholders want
Credit vs. Equity AnalysisWhat Creditors/Policyholders Want
  • Absolute Repayment
  • Minimize likelihood of loss of principal; benchmark is risk-free rate
  • Which translates into:
    • Conservative corporate governance
    • Prudent capital and financial management
    • Capital cushion
    • Strong earnings and cash flows

Industry Reserve Adequacy - Financial Analyst's Perspectives

credit vs equity analysis what shareholders want
Credit vs. Equity Analysis What Shareholders Want
  • Relative Return
  • Maximize total return, with acceptable level of risk; benchmark is a market index.
  • Which translates into:
    • Assertive corporate governance
    • High capital efficiency, as measured by ROE
    • Active capital and financial management
    • Growth in top and bottom lines
    • Strong earnings and cash flows

Industry Reserve Adequacy - Financial Analyst's Perspectives

credit vs equity analysis contrasting analytical styles
Credit vs. Equity Analysis Contrasting Analytical Styles
  • Basic Motivations
    • Equity and credit analysts both want to be right
    • Credit analysts have pressure from issuers to be more liberal and investors to be more conservative
    • Equity analysts can face substantial implied pressure from issuers
  • Inherent Bias
    • Credit analysts tend to focus on the downside risk
    • Equity analysts tend to focus on the upside opportunity

Industry Reserve Adequacy - Financial Analyst's Perspectives

credit vs equity analysis contrasting analytical styles example
Credit vs. Equity Analysis Contrasting Analytical Styles - Example
  • Trustworthy’s creditors/policyholders have NO upside

Industry Reserve Adequacy - Financial Analyst's Perspectives

industry reserve adequacy beyond the statement of opinion26
Industry Reserve Adequacy - Beyond The Statement of Opinion
  • Reserving Issues in Mergers and Acquisitions
    • Actuarial Due Diligence Process
    • Sampling of Solutions to Reserve Uncertainty

Industry Reserve Adequacy - Financial Analyst's Perspectives

reserving issues in m a actuarial due diligence process
Reserving Issues in M&AActuarial Due Diligence Process
  • Reserve Position
  • Restatement of Reported Results
  • GAAP Adjustments
  • Pro Forma Analysis
  • Appraisal Value

Industry Reserve Adequacy - Financial Analyst's Perspectives

actuarial due diligence process reserve position
Actuarial Due Diligence ProcessReserve Position
  • “Windshield” Analysis
  • Limited Review
    • Business Units
    • Access
    • Time
  • Comprehensive Analysis

Industry Reserve Adequacy - Financial Analyst's Perspectives

actuarial due diligence process restatement of reported results
Actuarial Due Diligence ProcessRestatement of Reported Results

Source: Consolidated Industry Loss Ratios

Industry Reserve Adequacy - Financial Analyst's Perspectives

actuarial due diligence process gaap adjustments
Actuarial Due Diligence ProcessGAAP Adjustments
  • Assets
  • DAC
  • Premium Deficiencies
  • Policyholder Dividends
  • Contingent Commissions
  • Salvage & Subrogation
  • Federal Income Taxes
  • Other
  • Present Value of Future Profits (PVFP)

Industry Reserve Adequacy - Financial Analyst's Perspectives

actuarial due diligence process pro forma analysis
Actuarial Due Diligence ProcessPro Forma Analysis

Assumptions:

  • Premium Growth
  • Earnings Pattern
  • Loss Ratio
  • Expense Ratio
  • Payout Patterns
  • Investment Portfolio Mix
  • Investment Yield
  • Risk Adjusted Discount Rate
  • Time Horizon

Industry Reserve Adequacy - Financial Analyst's Perspectives

actuarial due diligence process pro forma analysis32
Actuarial Due Diligence ProcessPro Forma Analysis

Output:

  • Income
  • Dividends
  • Surplus
  • Cash Flow From Operations
  • “Value”
  • Key Ratios, e.g. RBC

Industry Reserve Adequacy - Financial Analyst's Perspectives

reserving issues in m a

Reserving Issues in M&A

Sampling of Solutions to

Reserve Uncertainty

sampling of solutions
Sampling of Solutions
  • Purchase Accounting
  • Retrospective Adjustments
  • Reinsurance
  • Carve Outs
  • Other

Industry Reserve Adequacy - Financial Analyst's Perspectives

purchase accounting
Purchase Accounting
  • Reserves are increased by seller prior to transaction date
    • Purchase accounting does not allow acquirer to book additional reserves
    • Advantages
      • fattens the pig before it goes to market
    • Disadvantages
      • depresses surplus

Industry Reserve Adequacy - Financial Analyst's Perspectives

retrospective adjustments
Retrospective Adjustments
  • Future adjustment of sales price based on retrospective reserve estimates
    • Cash settlements
    • Portion of sales price held as a note payable
    • Contingent interest dividend paid to stockholders
    • Advantages
      • Low transaction cost
    • Disadvantages
      • Uncertainty

Industry Reserve Adequacy - Financial Analyst's Perspectives

reinsurance
Reinsurance
  • Stop loss cover provides protection against adverse reserve development
    • Purchased by seller
      • internal
      • external
    • Purchased by acquirer
    • Advantages
      • alleviates uncertainty associated with reserve development
    • Disadvantages
      • cost

Industry Reserve Adequacy - Financial Analyst's Perspectives

carve outs
Carve Outs
  • Segregation of “undesirable” business segments and exclusion from transaction
    • Prior to transaction
    • Post transaction
    • Strategic motives
    • Advantages
      • may be only way to attract buyers
    • Disadvantages
      • seller may retain unwanted business
      • Regulatory scrutiny

Industry Reserve Adequacy - Financial Analyst's Perspectives